A New Model of Venture Capital Risk and Return

Abstract

Risk and return are difficult to observe and measure due to the idiosyncrasies of venture capital: lack of public information, extreme returns, and infrequent prices. Cochrane (2005) found an alpha of 32% and a beta of 1.7 on a database covering 1987-2000. I use an updated and larger database with over 55,000 financing events and 10,000 returns covering 1987 to 2007. The returns model accounts for sample selection, endogenous holding periods and return outliers. In contrast to Cochrane, I find an alpha in a three-factor model of 27% and a beta of 2.4 which suggests venture capital investments earn excess returns and have a large systematic risk exposure. This is a significant drop from a raw alpha of 65% and increase of beta from 1.6 after correcting for sample selection, endogeneity and including the standard size and market-to-book factors. The mixture model results show that over 60% of all venture capital investments have a negative mean log return and substantial idiosyncratic volatility.

Keywords: venture capital, duration model, sample selection

JEL Classification: C41, G24